Brokerage firms unfortunately, and often in a self-serving effort to insulate themselves from liability, fail to report and most often fail to properly or accurately report to regulators the known misconduct or facts and circumstances surrounding a stockbroker’s termination. Many times brokerage firms actively conceal this information and fail to report this information to regulators to avoid regulatory scrutiny and because it appears on Public Disclosure, which may result in customer arbitration claims or lawsuits.
However the failure to reports adverse information is not only a violation of FINRA Rules but may also give rise to an action against the prior or non-reporting firm based upon its failure to warn its customers.
Article V, Section 3(b) of FINRA’s By-Laws similarly requires a member to amend a registered person’s Form U5 within 30 days of learning of any facts or circumstances causing any information previously set forth in the Form U5 to become inaccurate or incomplete, and the failure to do so is a violation of Article V, Sections 2(c) and 3(b), and Rule 2110. See, e.g., Daniel James Gallagher, Hearing Decision No. 2008011701203, June 13, 2011.
The accuracy of an applicant’s Form U-5 “is critical to the effectiveness” of a self-regulatory organization’s ability “to monitor and determine the fitness of securities professionals” The nature of the information is significant because the failure to file the amendments within the prescribed times deprived FINRA and the public of information concerning a pattern of problems at the firm and with the registered representatives. Id. See also, Department of Enforcement v. Warren William Wall, No.2007009472201 (Dec. 30, 2009)(Wall violated Conduct Rule 2110 and IM-1000-1 by filing a Uniform Termination Notice for Securities Industry Registration that misrepresented and omitted material facts concerning the termination of a registered representative). Dist. Bus. Conduct Comm. v. Nichols, Complaint No. C01950004, 1996 NASD Discip. LEXIS 30, at *30 (NASD NBCC Nov. 13, 1996)(The disclosure of truthful information on the Form U5 is crucial to the integrity of the securities industry’s public disclosure system and FINRA’s and other regulatory authorities’ investigatory efforts. McCrudden’s misconduct in this case inhibited FINRA’s investigatory system from operating as it should and concealed from potential employers and regulatory authorities the events that actually had transpired at HedgeCap).
It is of particular importance that the Form U5 is accurate because it “serves as a warning mechanism to member firms of the potential risks and accompanying supervisory responsibilities they must assume if they decide to employ an individual with a suspect history.” Henry Irvin Judy, 52 S.E.C. 1252,1256 (1997); Robert E. Kauffman, 51 S.E.C. 838, 839 (1993), aff’d, 40 F.3d 1240 (3d Cir. 1994); Rosenberg v. Metlife, Inc., 8 N.Y.3d 359, 866 N.E.2d 439, 834 NYS2d 494 (2007)(“The Form U-5 plays a significant role in the NASD’s self-regulatory process. Filing is mandatory within 30 days of termination of the registered representative and firms are subject to penalties should they fail to comply. Upon receipt of the Form U-5, the NASD routinely investigates terminations for cause to determine whether the representative violated any securities rules. The form “is often the first indication that the NASD receives regarding possible misconduct by members of the securities industry, and investigations of misconduct reported on the Form U-5 frequently lead to the initiation of disciplinary action by the NASD”).
Often but for the failure to accurately disclose to FINRA and a broker-dealers public customers the circumstances surrounding a bad broker’s termination, the continuation of wrongful conduct to others can prevented. Under such circumstances, brokerage firms have been routinely found liable to customers based upon the theory that the firm violated its statutory responsibilities by failing to report or not accurately reporting the misconduct or under a breach of fiduciary duty theory, that the brokerage firm had a duty to warn its (former) customers of the broker’s misconduct. See, S. Silver and S. Adkins, Brokerage Firms’ Liability When They Fail to Warn About Bad Brokers (Practicing Law Institute, Aug. 12, 2009).
The Failure to Warn is Actionable
Customers, including the customers of subsequent firms with which the offending broker becomes associated, have successfully maintained actions against a brokerage firm that fails to observe its regulatory responsibilities by failing to accurately and fairly disclose the circumstances surrounding a broker’s termination to regulators.
In Twiss v. Kury, 25 F.3d 1551 (C.A.11 (Fla.) 1994), from 1978 until January 1984, Kury was a registered sales representative with E.F. Hutton & Company, Inc. In 1983, Kury’s supervisor, Brown discovered that Kury had taken money from several of his clients in exchange for personal and corporate promissory notes. Brown subsequently asked Kury for a list of the people to whom Kury borrowed money and then sent letters to all such customers and asked them to verify that Hutton was not obligated on Kury’s promissory notes.
In February 1984, Hutton filed Form U-5 stating that Kury resigned, and that it had no “reason to believe” that Kury had violated any state or federal law or regulation or had “engaged in conduct which may be inconsistent with just and equitable principles of trade.” Following his termination with Hutton, Kury went to work as a registered sales representative with Prudential-Bache Securities Corporation.
Persons who became Kury’s clients subsequent to his resignation from Hutton, thereafter brought claims against Kury, Hutton, and several other defendants. The Court refused to dismiss the claims against Hutton because “the statutory provisions clearly imposed on Hutton, at the time Kury left its employ, a legal obligation to report the fact of his termination to the Department, to accurately state the reason for such termination, and to specify any illegal or unprofessional activity committed to Kury then known by Hutton. The rule required Hutton to make the report to the Department by filing a form U-5.”
The court further reasoned that those investors were within the class of persons these provisions were designed to protect “because they are investors in securities and dealt with Kury as a registered securities broker” and that the investors “suffered the type of injury the statutes were designed to prevent because they lost moneys invested as a consequence of the fraudulent acts of Kury.”
In the companion case in state court, Palmer v. Shearson Lehman Hutton, Inc., 622 So.2d 1085 (Fla. App. 1 Dist., 1993), the court held that “The law is settled that a statute creates a duty of care upon one whose behavior is the subject of the statute to a person who is in the class designed to be protected by the statute, and that such duty will support a finding of liability for negligence when the injury suffered by a person in the protected class is that which the statute was designed to prevent.” quoting, deJesus v. Seaboard Coast Line R.R. Co., 281 So.2d 198 (Fla.1973). “We conclude that the facts alleged in the complaints, if proven, are sufficient to show that Hutton’s statutory violation could be found by a reasonable person to be a proximate or legal cause of Appellants’ injuries.
The complaints essentially alleged that but for Hutton’s false and fraudulent reporting of Kury’s termination and Hutton’s failure to report Kury’s deceptive and fraudulent practices as the reason for his termination, action by the Department would have been taken in a timely fashion against Kury to prevent his reregistration and continued ability to further engage in such fraudulent practices through his association with other registered securities dealers, and thereby prevent future clients such as Appellants from “fall[ing] victim to his scheme.”
Similarly, in Dolin v. Contemporary Financial Solutions, Inc., 622 F.Supp.2d 1077 (D. Colo., 2009), the broker-dealer had obtained information that its broker, Bryant, had been selling unregistered promissory notes to his customers. The broker-dealer’s investigation, however, had been limited to contacting Bryant and relying on his denial that he was selling or soliciting Note Contracts. No one performed any review of Bryant’s financial accounts, contacted his customers, or conducted any investigation of the legality of the Note Contracts.
Contemporary Financial Solutions then filed a Form U-5, stating that Bryant’s departure was voluntary. The Form U-5 omitted any information regarding the Note Contracts and stated that Bryant was not the subject of investigation by any governmental body or any self-regulatory agency and was not under internal review for violating investment-related statutes, regulations, rules, or industry standards of conduct.
The Court found that “had Defendants taken the proper and timely course of action in their supervision and investigation of Bryant and reports to state and federal regulatory authorities, those authorities would have taken the necessary action to prohibit Bryant from selling Note Contracts. Instead, during 2004, while he was a registered representative of Defendants, Bryant sold over $3,000,000 in Notes, and he sold more than $10,000,000 in additional Note Contracts in 2005 and 2006.” Id.
In addition to finding Contemporary Financial Solutions liable because of the a fiduciary relationship between the plaintiffs and Bryant “because he had practical control over their accounts and acted as their investment advisor,” the Court found the basis to hold Contemporary Financial Solutions liable based upon the false, misleading, and/or inadequately investigated response to the broker-dealer’s investigation, as well as their filing of the false and misleading Form U-5 after the end of Bryant’s employment, in violation of various state statutes and regulations, including Colorado and Arkansas securities laws.
Also, in Episcopal Diocese of Central Florida v. Prudential Securities, 925 So.2d 1112 (Fla. App., 2006), in 1992, Prudential Securities fired Trumbo as a broker for mismanaging client funds. However, on his Form U-5, Prudential reported that Trumbo had been discharged after Prudential determined that his investment philosophy “was not consistent with the investment philosophy espoused by the firm.”
The Episcopal Diocese of Central Florida was one of Trumbo’s customers, and sometime in late August or early September 2000, Trumbo informed the Diocese that he was changing brokerage firms and obtained consent to move all four of its accounts to his new firm, Continental Broker Dealer, Inc., where the Diocese suffered substantial losses as a result of Trumbo’s mismangement of the Diocese’s account.
The Diocese then filed a tort action against Prudential seeking to recover damages for its investment losses at Continental, asserting that but for Prudential’s false reporting and breach of fiduciary duty, the Diocese never would have allowed Trumbo to manage the funds or transfer the funds to Continental and would not have suffered losses.
While the Diocese lost in arbitration, the Court vacated the arbitration award, holding that the Diocese’s tort claims against Prudential were outside of its agreement to arbitrate, and permitted the Diocese to bring these claims, de novo, in Florida state court.
The Failure to Warn is a Breach of Fiduciary Duty
Unlike the many cases where brokerage firms have been found liable to customers of the broker, at subsequent brokerage firms, where the broker gains employment and the losses occur, when the harm occurs to the broker-dealers own customers, or even prior customers, the broker-dealer has breached its fiduciary duties.
Securities brokers are fiduciaries that owe their customers a duty of utmost good faith, integrity and loyalty. See Davis v. Merrill Lynch. Pierce. Fenner & Smith, 906 F. 2d 1206, 121 14 (8th Cir. 1990); Biggans v. Bache Halsey Stuart Shields, Inc., 638 F. 2d 605, 610 (3d Cir. 1980); Jaksich, 582 F. Supp. at 502. Davis, 905 F. 2d at 1216 (a fiduciary relationship exists between a securities broker and customer because broker is a licensed professional who holds himself out as a trained and experienced person to render a specialized service); Mihara, 619 F. 2d at 824 (securities broker has a fiduciary duty to customer where broker knows or should have known that trust has been placed in him).
It is based upon this fiduciary relationship, and the duty to protect the accounts of its customers from third parties, specifically Respondent’s former agent, that Respondent can be held responsible for Claimant’s damages. Twiss v. Kury, 25 F.3d 1551 (C.A.11 (Fla.) 1994)(Under the common law, a person has no duty to control the conduct of another or to warn those placed in danger by such conduct unless a special relationship exists between the defendant and the persons whose behavior needs to be controlled or the foreseeable victim of such conduct).
Even under the circumstances where a when the broker-dealer files an accurate Form U-5, it can be held responsible based upon its failure to warn its customers (to whom it owes a fiduciary duty). For example, in SII Investments, Inc. v. Jenks, 370 F.Supp.2d 1213 (M.D. Fla., 2005), Jenks opened an account with SII and their broker Urick, a registered representative of SII in 2000. Thereafter, on May 15, 2001, SII asked Urick to leave the firm, and SII disclosed on Urick’s Form U-5 that: “Some of Mr. Urick’s activities were inconsistent w/ the firm’s overall business strategies. He was the subject of three customer complaints ytd., although no conclusion of any violation or wrongdoing was reached. It was mutually agreed that he would engage a new broker dealer.”
Jenks expected SII to notify her of any problems with Urick. However, SII did not inform Jenks that three customer complaints had been filed against Urick, that SII was not comfortable with Urick’s business practices, and that SII had requested that Urick leave. Jenks alleged that had SII disclosed this information to her, she would have stopped doing business with Urick. Not having this information, Jenks moved her account to Rosenthal Collins, because she believed that Urick was a trustworthy broker who left SII voluntarily and on good terms in order to obtain a position of greater responsibility. Jenks relied on Urick’s July 2000 representations and subsequently invested $310,000 after she moved her account to Rosenthal Collins, which the Court found grew out of and were a natural consequence of Urick’s recommendation, made while he was associated with SII.
Based upon SII’s failure to disclose that it terminated Urick and warn Jenks as to the reasons his termination, the Court found that Jenk’s claims arose in connection with SII’s business activities and ordered the parties to submit to arbitration. Jenks went on to win a $446,000 Arbitration Award against SII based upon SII’s failure to warn Jenks. (NASD Dispute Resolution Arbitration No. 05-00373).
Similarly, in Glaziers and Glassworkers Union Local No. 252 Annuity Fund v. Newbridge Securities, Inc., 93 F.3d 1171 (3rd Cir. 1996), the broker, Lloyd was being investigated by Janney because of suspected improprieties in Lloyd’s personal investments. Lloyd had failed to make a payment to a partnership in which he was a limited partner, and Janney had come to suspect that he had tried to cover-up the late payment by tendering a cashier’s check that had been fraudulently altered to create the appearance that it had been timely presented.
In June 18, 1985, Lloyd resigned from Janney, and although Janney disclosed the circumstances surrounding his termination, that Lloyed was believed to have altered checks, Janney did not inform the Union pension fund of the circumstances surrounding Lloyd’s departure.
After the Funds transferred their accounts to Lloyd’s new firm, the Funds expanded the type and scope of investments which they permitted Lloyd to make on their behalf. The relationship with Lloyd continued until March, 1990, when the Funds learned that Lloyd and his new firm were under investigation by the SEC and, concerned over the handling of their investments, finally terminated their relationship with Lloyd. However, by that time, Lloyd had stolen Fund assets in excess of $500,000 and had wasted additional assets in excess of $2,000,000 in what the Funds refer to as “bizarre and worthless investments.” Id. at 1177.
Holding that the Union has adequately stated a claim against Janney based upon its failure to warn, the Court stated that a fiduciary has a fundamental duty to furnish information to a beneficiary. “This duty to inform is a constant thread in the relationship between beneficiary and trustee; it entails not only a negative duty not to misinform, but also an affirmative duty to inform when the trustee knows that silence might be harmful.” quoting, Globe Woolen Co. v. Utica Gas and Electric Co., 224 N.Y. 483, 121 N.E. 378, 380 (1918) (“A beneficiary, about to plunge into a ruinous course of dealing, may be betrayed by silence as well as by the spoken word.”)(Cardozo, J.).
In sustaining the Union’s breach of fiduciary duty claim, the Court stated that “If Janney was a fiduciary, it could not turn its “practiced eye” to its self-interest, while turning a blind eye to the interests of its beneficiary, and that “a fiduciary, is under a duty to communicate to the beneficiary material facts affecting the interest of the beneficiary which he knows the beneficiary does not know and which the beneficiary needs to know for his protection in dealing with a third person.” Glaziers and Glassworkers, 93 F.3d at 1181.
The Court also noted that there was a dispute concerning Janney’s motivations and the materiality of the information not volunteered, which the Funds argued, that Janney withheld out of a fear of being sued, and a concern for its own well being. however the Court did conclude that “ Janney’s failure to disclose creates an issue of fact as to whether it acted with the exercise of “care, skill, prudence and diligence,” and if not, whether failure to do so caused Lloyd’s subsequent loss.
Accordingly, the failure to report or accurately report the adverse facts and circumstances surrounding a terminated stockbroker’s termination of the active concealment of this information from customers is actionable, and investors suffering losses as a result of subsequent bad conduct may be able to recover their investment losses.
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